5 tax myths (part 1)
Wednesday, June 6th, 2012
We got a call recently from a client asking if he should finance an equipment purchase to lower his tax bill. First, I commended him for thinking ahead about taxes and for calling us for feedback about his financial decision. Then I asked him if it made good business sense for him to do this deal without regard to the tax impact.
It goes back to the old adage, “Don’t let the tax tail wag the dog.” Taxes are important, but they are seldom the most important factor in a financial decision. Even at the highest personal rate, tax is still a small fraction of the overall financial picture.
With a nod to Tim Maurer, contributor to Forbes magazine, we’ll take a look at the first three of five tax myths today:
- Myth: Keep a mortgage for the tax deduction.
Yes, you can deduct all or most of your mortgage interest, reducing your tax bill, but interest is only part of that monthly payment. You are also paying principal back to the bank. Let’s say you are in the 25% marginal tax bracket, and you have a monthly mortgage payment of $1,000. Let’s assume that, on average, $400 of that is interest. So for the year, $4,800 of the $12,000 in payments is deductible, resulting in a tax savings of $1,200. This is only 10% of your payments, and this percentage decreases over time as you pay down the balance. Your overall financial position may be stronger if you use available funds to pay off the loan faster.
The primary purpose of a mortgage or other loan is to gain the use of the property now rather than later. Is that benefit worth the cost of the loan? The tax benefit is not a major determining factor. In fact, some say it is built into the price of the property.
- Myth: Don’t sell this stock because you’ll owe tax on the gain.
A good investment will increase in value over time. Capital gains tax is the price of that good decision. If you sell a stock for $200 that you bought for $100 more than a year ago, you pay $15 tax (generally) on the $100 gain. That means you pocket $85. If you hold onto the stock to avoid the tax, your money is tied up in the stock, meaning you cannot use it for something else (opportunity cost). If the stock subsequently declines in value, you miss out on the gain as well as the alternative use of that money. Is that worth avoiding the 15% tax?
Don’t hold onto an investment solely to avoid taxes. You made that investment for specific reasons. If the investment no longer makes sense using those criteria, then consider selling. The tax impact is only one factor in the decision.
- Myth: Buy this investment to reduce your taxes.
You may have heard the pitches for various investments based on tax advantages. Limited partnerships once were touted as vehicles for generating tax losses until the IRS changed the rules. Many investors in limited partnerships lost real money when they pulled out or the partnerships went under. Other investments such as annuities and municipal bonds are sometimes sold on the merits of their tax benefits.
Various investments have their places in a well-planned strategy based on your goals, financial position, and comfort level. Tax benefit should not be a primary reason for buying an investment.
When you are considering a major financial decision like a purchase, it pays to consult an advisor such as a CPA to discuss the ramifications and options.